You likely formed an S corporation to save on self-employment taxes. If so, is your S corporation salary nonexistent, too low, too high or just right?
Why your S corporation salary matters
Getting the salary right is important, for three reasons.
- Taxes and penalties. If the IRS finds your salary too low, you will owe income and payroll taxes on the shortfall. On top of that, you may owe payroll and income tax penalties that can cost plenty.
- A wider audit. In most cases, the IRS will expand the audit to three years. Then it adds the extra income and penalties for each of those years.
- A higher salary going forward. After an audit, you are likely stuck with the higher salary. As a result, you lose the savings you formed the S corporation to get.
How to set a reasonable S corporation salary
The IRS did owners a big favor when it released its Reasonable Compensation Job Aid for IRS Valuation Professionals. For the basic rules, see the IRS page on S corporation compensation.
The IRS says the job aid is not an official position or authority. Even so, it helps a lot. It gives clear valuation rules to follow, and it removes some of the gray areas. The job aid describes several approaches.
Market approach
The market approach compares your business with similar businesses. Then it looks at what those businesses pay employees in roles like yours. Usually, that means the shareholder-employee who serves as CEO.
The key question is simple. What would a similar company pay a non-owner for the same job in an arm’s-length relationship? According to the job aid, courts favor this approach. However, matching employees at comparable companies is hard. For that reason, the IRS also developed other approaches.
Cost approach
The cost approach breaks your work into its parts. For example, these may include management, accounting, finance, marketing, engineering, purchasing, bookkeeping and even janitorial tasks. Then it assigns a market wage to the time you spend on each one.
The example below shows how the cost approach supported a $71,019 salary. The owner’s corporation had $3.5 million in revenue and 19 employees.
Other pay that counts toward your S corporation salary
Health insurance
Your S corporation may pay or reimburse health insurance for you and your family. If so, that amount goes on your W-2 and counts as compensation. However, it is not subject to payroll taxes. So it fits nicely into a payroll tax savings strategy.
Retirement plan contributions
Employer contributions for you to a defined benefit plan, SEP or 401(k) also count as compensation. Yet they don’t trigger payroll taxes either. As a result, they add to your reasonable compensation while still saving payroll taxes.
Planning note: Your S corporation salary sets how much the corporation can contribute to your SEP or 401(k). By comparison, a defined benefit plan likely allows a larger contribution for you.
The Section 199A deduction
Finally, the S corporation’s net income passes through to you as a shareholder. That income may qualify for the 20% Section 199A deduction on your Form 1040.
Get help with your S corporation salary
Setting a salary you can defend takes careful analysis. We are here to help. Call us at (415) 842-2940 or book a free 15-minute call.